Simple AFTF Example

The AFTF accounting model is both relevant and reliable. It is also simple and natural, although those experienced with the GAAP implementation may initially consider it unnatural. This essay provides a simple and approachable illustration.

Example 1 shows actual net[1] cash flows for 5 past years (validation period) and for year 6, the current reporting year for a hypothetical company. A linear fit and extrapolation using the Excel TREND function provides a simple set of modeled net cash flows[2].

The first part of the dual validation requires that the cash flow model at least fits the recent past. For the simple model presented this translates into a requirement that the sum of modeled net cash flows over the 5-year validation period match the sum of actual net cash flow over the same period. Conveniently this matching is a by-product of the linear fit, i.e., the use of the Excel TREND function guarantees this.

The second part of the dual validation requires that the sum of present values of modeled net cash flows must match the sum of actual company stock prices. Modeled net cash flows form a basis for a company valuation but these may be undisciplined and may not be scaled to independent or consensus valuations. The capital markets provide an independent and unequivocal economic valuation scale. This scaling of values is accomplished by using the appropriate discount rate, called the historic cost of capital[4], in calculating present values. This rate is easily obtained using the Excel GOAL_SEEK tool. The underlying assumption is that the capital markets have correctly valued the company over the validation period and that the capital market pricing accurately determines the cost of capital.[5]

Note that it is difficult and unprofitable for management to exaggerate modeled cash flows. First, the model must fit actual past experience. Second, the discount rate rises to offset inappropriate cash flows so that the present values always represent economic (capital market scaled) values. Third, the cash flow actual-to-expected ratio (A/E) will reveal management’s failure to judge or perform. The capital markets extract a swift and sure penalty if management fails to meet its own stated goals.

AFTF financial reporting consist mainly of the elements shown in the tables: a statement of values, value added, A/E results, and the cost of capital. See Appendix 3 of the draft proposal Accounting For The Future for more details.[6]

Example 2 shows the effect of new information, for example, a computer purchase. In Example 2, the computer purchase cost $20,000 in the current year (year 6) and delivers benefits and savings of $5,000 in each future year. The difference between the values added in the two examples is the value added by the computer purchase and is exactly what a normal cost/benefit analysis of any capital investment would reveal.[7] Generally, AFTF is an extension of the cost/benefit decision technology in common use by accountants.

For further information, see the draft proposal Accounting For The Future or the numerous essays at my website at:

[1] In this simple example we use net cash flows. This is the minimum detail required. In practice, individual cash inflows and outflows would be modeled, the present values of which would be AFTF assets and liabilities, respectively. We would generally require that each modeled cash flow component exactly match the actual component over the 5 year validation period, but not for each year.

[2] In practice, a linear model might be replaced by sophisticated non-linear models with many inputs and inter-relationships between cash flow components. This is not part of the AFTF accounting model per se. It would be up to management to use or create models considered representative. Sophisticated or “accurate” models are not required for AFTF! Even a simple linear model of only net cash flows would produce a vast improvement in relevance over the current GAAP implementation.

[3] See the essay Disciplining Prospective Accounting for a more detailed discussion of the dual validation.

[4] See the essay The Historic Cost of Capital for a detailed discussion of the meaning, function and characteristics of this discount rate. This rate is a market consensus total discount rate including provision for the time value of money, inflation expectations, risk (outcome variance), investor confidence, residual market inefficiency, etc.

[5] It is possible that the capital market scale is misguided. If so, this is probably due to bad or irrelevant information delivered by the current accounting model. AFTF will quickly force convergence to an economic value scale because it informs and is informed by the capital markets.

[6] The stock price and the AFTF value will converge so that the ratio of Price to PVECF will be normalized at 1.00 for all industries. Value added will be normalized at zero so that economic progress is immediately clear.

[7] AFTF measures positive value added. In contrast, the GAAP measure of the computer purchase would be negative or zero (if fully capitalized); this does not represent economic value or promote good management or shareholder decisions.